HOW CRYPTOCURRENCIES WORK

HOW CRYPTOCURRENCIES WORK

The source codes and technical controls that support and secure cryptocurrencies are highly complex. However, laypeople are more than capable of understanding the basic concepts and becoming informed cryptocurrency users.

Functionally, most cryptocurrencies are variations on Bitcoin, the first widely used cryptocurrency. Like traditional currencies, cryptocurrencies’ express value in units – for instance, you can say “I have 2.5 Bitcoin,”just as you’d say, “1 have $2.50.”

A cryptocurrency’s block chain is the master ledger that records and stores all prior transactions and activity, validating ownership of all units of the currency at any given point in time. As the record of a cryptocurrency’s entire transaction history to date, a block chain has a finite length containing a finite number of transactions -that increases over time.

Identical copies of the block chain are stored in every node of the cryptocurrency’s software network the network of decentralized server farms, run by computer-savvy individuals or groups of individuals known as miners who continually record and authenticate cryptocurrency transactions.

A cryptocurrency transaction technically isn’t finalized until it’s added to the block chain, which usually occurs within minutes. Once the transaction is finalized, it’s usually irreversible unlike traditional payment processors, such as PayPal and credit cards, most cryptocurrencies have no built-in refund or chargeback functions, though some newer cryptocurrencies have rudimentary refund features.

During the lag time between the transaction’s initiation and finalization, the units aren’t available for use by either party. The block chain thus prevents double-spending, or the manipulation of cryptocurrency code to allow the same currency units to be duplicated and sent to multiple recipients.

Private Keys

Every cryptocurrency holder has a private key that authenticates their identity and allows them to exchange units. Users can make up their own private keys, which are formatted as whole numbers between 1 and 78 digits long, or use a random number generator to create one. Once they have a key, they can obtain and spend cryptocurrency. Without the key, the holder can’t spend or convert their cryptocurrency rendering their holdings worthless unless and until the key is recovered.

While this is a critical security feature that reduces theft and unauthorized use, it’s also draconian losing your private key is the digital equivalent of throwing a wad of cash into a trash incinerator. While you can create another private key and start accumulating cryptocurrency again, you can’t recover the holdings protected by your old, lost key.

Wallets

Cryptocurrency users have “wallets” with unique Information that confirms them as the temporary owners of their units. Whereas private keys confirm the authenticity of a cryptocurrency transaction, wallets lessen the risk of theft for units that aren’t being used. Wallets used by cryptocurrency exchanges are somewhat vulnerable to hacking -for instance, Japan-based Bitcoin exchange Mt. Gox shut down and declared bankruptcy after hackers systematically relieved it of more than $450 million in Bitcoin exchanged over its servers.

Wallets can be stored on the cloud, an internal hard drive, or an external storage device. Regardless of how a wallet is stored, at least one backup is strongly recommended. Note that backing up a wallet doesn’t duplicate the actual cryptocurrency units, merely the record of their existence and current ownership.

Miners

Miners serve as record-keepers for cryptocurrency communities, and indirect arbiters of the currencies’ value. Using vast amounts of computing power, often manifested in private server farms owned by mining collectives comprised of dozens of individuals, miners use highly technical methods to verify the completeness, accuracy, and security of currencies’ block chains. The scope of the operation is not unlike the search for new prime numbers, which also requires tremendous amounts of computing power.

Miners’ work periodically creates new copies of the block chain, adding recent, previously unverified transactions that aren’t included in any previous block chain copy effectively completing those transactions. Each addition is known as a block. Blocks consist of all transactions executed since the last new copy of the block chain was created, usually a few minutes prior.

The term “miners” relates to the fact that miners’ work literally creates wealth in the form of brand-new cryptocurrency units. In fact, every newly created block chain c0py comes with a two-part monetary reward: a fixed number of newly minted (‘mined”) cryptocurrency units, and a variable number or existing units collected from optional transaction fees (typically less than 1% of the transaction value) paid by buyers. Thus cryptocurrency mining is a potentially lucrative side business for those with the resources to invest in power and hardware-intensive mining operations.

Though transaction fees don’t accrue to sellers, miners are permitted to prioritize fee-loaded transactions ahead of fee-free transactions when creating new block chains, even if the fee free transactions came first. This gives sellers an incentive to charge transaction fees, since they get paid faster by doing so, and so it’s fairly common for transactions to come with fees. While it’s theoretically possible for a new block chain copy’s previously unverified transactions to be entirely fee-free, this almost never happens in practice.

Through instructions in their source codes, cryptocurrencies automatically adjust to the amount of mining power working to create new block chain copies – copies become more difficult to create as mining power increases, and easier to create as mining power decreases. The goal is to keep the average interval between new block chain creations steady at a predetermined level for instance, Bitcoin’s is 10 minutes.

Finite Supply

Although mining periodically produces new cryptocurrency units, most cryptocurrencies are designed to have a finite supply. Generally, this means that miners receive fewer new units per new block chain as time goes on. Eventually, miners only receive transaction fees for their work.

This has yet to happen with any extant cryptocurrency, but Observers predict that the last Bitcoin unit will be mined sometime in the mid-22nd century, if current trends continue. Finite-supply cryptocurrencies are thus more similar to precious Metals, like gold, than to fiat currencies ~ of which, theoretically, unlimited supplies exist.

Cryptocurrency Exchanges

Many lesser-used cryptocurrencies can only be exchanged through private, peer-to-peer transfers, meaning they’re not Very liquid and are hard to value relative to other currencies both crypto and fiat.

More popular cryptocurrencies, such as Bitcoin and Ripple, trade on special secondary exchanges similar to forex exchanges for hat currencies. (The now-defunct Mt. Gox is one example.) These platforms allow holders to exchange their cryptocurrency holdings for major fiat currencies, such as the U.S. dollar and euro, and other cryptocurrencies (including less-popular currencies). In return for their services, they take a small cut of each transaction’s value -usually less than 1%.

Cryptocurrency exchanges play a valuable role in creating liquid markets for popular cryptocurrencies and setting their value relative to traditional currencies. However, exchange pricing can still be extremely volatile -Bitcoin’s U.S. dollar exchange rate fell by more than 50% in the wake of Mt. Gox’s collapse, for instance.

The Anatomy of Cryptocurrency

Although there can be exceptions to the rule, there are a number of factors that make cryptocurrency so different from the financial systems of the past:

Adaptive Scaling: Adaptive scaling essentially means that cryptocurrencies are built with a number of measures to ensure that they will work well in both large and small scales.

A number of other measures are included in digital coins to allow for adaptive scaling including limiting the supply overtime (to create scarcity) and reducing the reward for mining as more total coins are mined.

Adaptive Scaling Example: Bitcoin is programmed to allow for one transaction block to be mined every ten minutes. The algorithm adjusts after every 2016 blocks (theoretically, that’s every two weeks) to get easier or harder based on how long it actually took for those 2016 blocks to be mined. So if it only took 13 days for the network to mine 2016 blocks that means it’s too easy to mine, so the difficulty increases. However, if it takes 15 days for the network to mine 2016 blocks that shows that it’s too hard to mind, so the difficulty decreases.

Cryptographic: Cryptocurrency uses a system of cryptography (AKA encryption) to control the creation of coins and to verify transactions.

Decentralized: Most currencies in circulation are controlled by a centralized government, and thus their creation can be regulated by a third party. Cryptocurrency’s creation and transactions are open source, controlled by code, and rely on “peer-to-peer” networks. There is no single entity that can affect the currency.

Digital: Traditional currency is defined by a physical object (USD representing gold for example), but cryptocurrency is all digital. Digital coins are stored in digital wallets and transferred digitally to other peoples’ digital wallets. No physical object ever exists.

Open Source: Cryptocurrencies are typically open source. That means that developers can create APIs without paying a fee and anyone can use or join the network.

Proof-of-work: Most cryptocurrencies use a proof-of-work system. A proof-of-work scheme uses a hard-to-compute but easy-to-verify computational puzzle to limit exploitation or cryptocurrency mining. Essentially, it’s like a really hard to solve “catpcha” that requires lots of computing power.

Pseudonymity: Owners of cryptocurrency keep their digital coins in an encrypted digital wallet. A coin-holder’s identification is stored in an encrypted address that they have control over it is not attached to a person’s identity. The connection between you and your coins is pseudonymous rather than anonymous as ledgers are open to the public (and thus, the ledgers could be used to glean information about groups of individuals in the network).

Value: For something to be an effective currency, it has to have value. The US dollar used to represent actual gold. The gold was scarce and required work to mine and refine, so the scarcity and work gave the gold value. This, in turn, gave the US dollar value.

Cryptocurrency works with a similar concept. In cryptocurrency, “coins” (which are nothing more than publicly agreed on records of ownership) are generated or produced by ‘miners”. These miners are people who run programs on specialized hardware made specifically to solve proof-of-work puzzles. The work behind mining coins gives them value, while scarcity of coins and demand thereof causes their value to fluctuate. The idea of work giving value to currency is called a ‘proof-of-work” system. The other method for validating coms is called proof-of-stake. Value is also created when transactions are added to public ledgers as creating a verified “transaction block’ takes work as well.